Moody's analysis contemplates 44% drop in Canadian housing prices

A severe economic shock, such as the kind that hit Japan in the early 1990s and California and Nevada in 2006, could knock Canadian housing prices down by 44%, according to a formula devised by Moody’s Investors Service

A severe economic shock, such as the kind that hit Japan in the early 1990s and California and Nevada in 2006, would have to knock Canadian housing prices down by 44% to cause securities linked to Canadian mortgages to lose the highest ratings assigned by Moody’s Investors Service.

Such a house price decline, were it to happen, would be driven primarily by the phenomenal upswing in Canadian home prices over the past decade, Moody’s said.

Canada joins Spain, as well as the United Kingdom and Australia, in the ratings agency’s assessment of countries where growth in housing prices over the past 10 years has driven their values away from sustainable market fundamentals and into “overheated” territory.

“As with Australia, Spain and the U.K., we expect house prices in Canada to suffer the most due to the misalignment of current house prices with historic fundamentals,” Moody’s said.

The ratings agency released the report Monday that included its housing market analysis, along with request for comment on its proposed approach to analyzing the credit risk of non-insured mortgage pools.

“Moody’s Investors Service is in no way predicting the extent nor the causes of a large scale house price depreciation in Canada,” spokesperson Thomas Lemmon said in an emailed statement.

“Along with many other factors, the home price component of our analysis provides that in order to achieve our highest rating, a mortgage pool would have to be able to withstand a 44% downturn.”

Moody’s is the second ratings agency in as many weeks to seek input on a proposal to change the methodology used to analyze securities linked to mortgages.

Last week, London and New York-based Fitch Ratings unveiled a proposed a two-step model that reduces home prices to a “sustainable” value based on a number of factors including data provided by Canadian banks. It then further subjects the homes to a “stressed market” value decline assumption.

Fitch said Canadian home prices are overvalued by about 20%.

Ratings agencies came under harsh criticism in the aftermath of the financial crisis of 2008 for what was perceived as a failure to predict the U.S. housing market meltdown that precipitated it.

Since then, there has been an attempt to strike a balance of thorough analysis with timely analysis, according to Grant Connor, an associate in equity research at National Bank Financial who previously worked on structured finance at Moody’s.

As with Australia, Spain and the U.K., we expect house prices in Canada to suffer the most

The model proposed by Moody’s on Monday determines house price “stress” rates, used to assign ratings, by looking at variable factors such as house price and income growth over 10 years, and fixed factors such as monetary policy.

The analysis of housing prices in the event of economic shocks includes data from Finland in 1989, Japan in 1991, and Hong Kong in 1997, as well as Ireland, Nevada, and California in 2006.

The “variable” analysis assesses how much current house prices have departed from “sustainable” market fundamentals. The assumption is that, in the event of a severe economic shock, expected demand that has been baked into current house prices will not materialize. In Canada, the growth in house prices over the past 10 years has ‘’far outstripped” the growth in incomes, according to Moody’s.

“Think of it like an elastic [being stretched],” explains Mr. Connor of National Bank Financial. “The snap back is going to be a lot harder.”

Moody’s also assesses the “fixed” factor, which rates how vulnerable the consumer is to economic shocks, whether there is a large oversupply of houses, how effectively monetary policy can alleviate the shock, and how dependent the economy is on the real estate sector.

Canada scores better in this area, said Mr. Connor, because the stability of the country and its monetary policy is taken into consideration. While Canada’s household debt to income ratio is very high, at 154%, Moody’s notes that savings rates are higher than in some jurisdictions such as the United Kingdom.

In addition, Moody’s does not seem overly concerned about an over-supply of housing with the possible exception of the condominium market.